(Non)sense of blockchain startup valuations
Why most blockchain fundraise valuations are overvalued and what extreme outcomes one must achieve to have a profitable venture portfolio.
The majority of blockchain startups raise money. Why is that the case?
- Abundance of venture capital seeking to be deployed.
- Scarcity and resulting high salaries of software engineers, especially those who can write Solidity, Rust and other blockchain languages.
- Race to be first or capture market share.
Valuations on blockchain startups are, by conventional standards, outrageous. Pre-seed companies without an MVP, beta or paying users are regularly (successfully) raising at >$10mm post-money valuations for equity. This stage is usually priced between $1-5mm, perhaps up to $10mm for founders who have successfully exited before or have gone through YCombinator. Even in these bear market conditions, we're still seeing such raises succeed. These conditions result in founding teams, even if they have a technical co-founder, to raise - because they can.
I'm skeptical of this and one of the things my crew and I at Deus Ex DAO struggle with is the overvaluation of the decks that come across our desk. This skepticism is contrarian in a sense, since we often get these deals from partners who have decided to invest at an astronomical valuation. Token deals differ slightly in that often 50% or so of the token supply is allocated for liquidity mining, ecosystem and treasury funding.
How to think about token vs. equity deals:
A $15mm post-money pre-seed token deal on a SAFT (Simple Agreement for Future Tokens) is thus roughly the same as a $7.5mm post-money equity deal with a token warrant that converts with a 50% dilution.
Having founded and bootstrapped multiple companies myself, I prefer it when teams go to market with traction. Getting traction without funding is possible in most industries, it's just harder. It requires non-technical founders find a technical co-founder who is willing to work out of passion and for equity. Or paying a team or agency out of pocket or in equity to create an MVP. The creativity, persuasion and commitment this requires from founders is an important test that I think is a key screen to filter for when reviewing early stage companies. This is in stark contrast to founders who can't/won't commit to their company until they've raised funds. These pitches find success far too often still, which does not enforce good habits.
I hear a few common responses to the question of "what warrants this high valuation?":
- XYZ big shot is investing.
- They are raising their next round at 2x this round's price.
- And they are selling to the public at 2x the next round's price (e.g. via a Liquidity Balancer Pool, Launchpad public sale or equivalent).
The first argument is hard to argue with. This is a market and price is where buyers and sellers transact. But finding an incremental buyer at consistently higher valuations is harder as the numbers grow and are subject to conducive conditions (e.g. not bear markets!).
Then there's the question of vesting. Historically, blockchain projects that sold tokens allowed the vesting of substantial amounts of insider tokens at the Token Generation Event ("TGE"), so that they could realise gains. While wearing the seed investor hat, this may be attractive, it is rarely in the best interest of a project. We prefer it when teams and investors are aligned for the long term. A 6-12 month cliff (before the tokens start vesting) and 12-36m linear vesting is more appropriate. Nonetheless, even if a more reasonable vesting schema is adopted and the company manages to raise up-rounds, when tokens are at play, there's often the issue of constant selling that needs to be counteracted with ponzinomics. I think most investors overestimate the odds they will be able to sell their tokens profitable over a 12-24m period with liquidity mining in place.
As I learn more about venture capital, I'm struck by the magnitude of the outcomes you need to have to run a profitable venture portfolio.
Let's run some numbers.
Say we invest $250K evenly in 10 blockchain startups. These are all pre-seed equity deals at $10mm post-money valuation. Your starting stake in each company is $25K for 0.25% ownership.
A winning company raises 3 successive rounds before they exit. We don't use our pro-rata rights to avoid dilution. Say each successive round increases the valuation 2x and 10% of shares are issued in each round, resulting in 30% total dilution.
After 3 rounds (seed, series A, series B) the company is worth $80mm post-money ($10mm * 2^3). The exit happens at 2x that valuation, so $160mm post-money ($80mm * 2).
After the 3 rounds, your stake of the company is diluted 30% from 0,25% to 0,19% (0,25% / 1,3). At the $80mm Series B valuation, it's worth $153.846 (6,15x of your $25.000 initial stake). At the exit, it's double that, so $307.692 (0,19% of $160mm post-money valuation), a 12,31x return on your initial $25K.
Now let's just say this scenario is *very* rare. Popular venture capital stats indicate that it's reasonable to assume that 70% of investments go to $0 and that the remainder need to both cover those losses and generate the returns.
Say we aspire to 3x cash on cash across 10 years for the $250K we've invested in this venture portfolio. If 7 companies go bust, our stakes in the remaining 3 need to generate (assuming no management fees, costs etc.) $750K in total for this return. If we average this across the three remaining companies, it means our stakes need to be worth $250K. Taking the fundraising and exit path we've just described, it means each one needs to achieve at least a $131.58mm market cap upon exit (13,1x from the $10mm post-money valuation at which we invested).
The above numbers are simplified. They presume this is your own money and that there are no fees or other expenses. But the message is clear: it would require 3 out of 10 companies to 13x their valuation in 10 years for you to achieve 3x cash on cash (equivalent to a 11,61% Compound Annual Growth Rate - a S&P beating return). If only 1 company gets this 13x outcome, you'd only get your money back ($250K returned on $250K initial) - but in real terms (after inflation) you will have lost money, let alone the opportunity cost of not investing it elsewhere.
What happens if you change the starting valuations to the outrageous prices we're (still) seeing in crypto? If the pre-seed rounds were priced at $20mm post-money, then for a 13,1x we'd need $262mm exit valuations. Here the law of large numbers applies again - the higher we go, the less likely the outcome.
This is why I'm resolved to remaining prudent. Venture is fun. I enjoy working closely with teams, contributing to their trajectory and being an early user of products. However, I suspect that to get good long-term outcomes will require price restraint and skepticism. Additionally, like my friend Cosmo of Nova River echos, the market for liquid tokens is attractive, since there are tokens of good projects trading at or below private round prices - where most insiders have already vested and thus less overhanging sell pressure.
Striking Markets Newsletter
Reflections on blockchain, markets and venture capital.